How Deep Is Your Moat?

When we think about economic moats at Morningstar, we focus on the longevity of firms' competitive advantages. In our view, the width of a company's economic moat is determined by how long the firm can generate excess economic returns. Firms that are likely to keep competition at bay for a very long time have wide moats, those with identifiable competitive advantages of uncertain duration have narrow moats, and companies that could see their returns competed away very quickly have no moat.

Notice, though, that our moat rating is not dependent on the size of a company's returns on capital. For example, pipelines like  Kinder Morgan Energy Partners   generate returns on capital that just exceed their cost of capital, whereas firms like  Johnson & Johnson (JNJ) or  Applied Materials (AMAT) return more than 30% on their capital base. Yet all three are wide-moat stocks because we think their excess returns will persist for a very long time.

This table shows the lowest and highest returns on invested capital that we expect for wide-moat firms that we cover:

Lowest and Highest Returns on Capital for Wide-Moat Companies
Company	Industry	Expected ROC*	Risk
Kinder Morgan Part.	Pipelines	8.9%	Below Average
Northern Border	Pipelines	9.3%	Below Average
Teppco Partners	Pipelines	10%	Below Average
Magellan Mid. Part.	Pipelines	11.1%	Average
Pitney Bowes (PBI)	Office Equip.	11.2%	Below Average
Moody's (MCO)	Bond Rating	117%	Below Average
Adobe (ADBE)	Software	112%	Average
Linear Technology	Semiconductors	105%	Average
Strayer Education (STRA)	Education	103%	Average
Apollo Group	Education	80%	Average
* Average

Are companies like  Strayer (STRA) and  Microsoft (MSFT) better businesses than  Teppco Partners  or  Pitney Bowes (PBI), even though they all have wide moats? Well, yes, because Strayer and Microsoft have deeper moats--that is, they can generate more cash per dollar of invested capital. Of course, they're also very different businesses, with somewhat less predictable cash flows and higher growth rates. A pipeline company would fill a very different role in your portfolio than would a chip company like  Linear Technology  , or a software company like  Adobe (ADBE).

The point here is that not all wide-moat companies are created equal. Some have fairly shallow economic moats and generate slim excess returns, while some generate returns on capital that would make even Bill Gates blush--not that Microsoft's are shabby. All else equal--and assuming a reasonably priced stock--a company with a wide and deep moat is likely to be a better long-term investment than one with a wide and shallow moat.

No-Moat Wonders
But what about companies that earn high returns on capital without a moat? We cover a number of companies, mainly in technology and retail, that carry moat ratings of "none" yet boast impressive returns on capital. However, we don't think those fat returns are sustainable over the long haul.

Take teen retailer  Aeropostale  or software firm  Citrix , for example. Each generates very respectable returns on capital (in the high teens to low 20s), but we have not been able to identify any reason why those returns will be sustainable. Teen apparel retailing is intensely competitive and fad-driven, so one misstep by Aeropostale's management team--or an unexpected change in teen tastes--could put a quick damper on the firm's profitability. Citrix, meanwhile, is locked in an unstable relationship with Microsoft and faces the very real risk that its technology could be obsolete down the road.

Both these companies could be fine investments at the right price--Aeropostale, in fact, has a 5-star Morningstar Rating for stocks at the moment--but they would both require a close watch, and they are unlikely to be good long-term holdings unless they develop some kind of moat. After all, it's tough to predict the future of companies without economic moats, which is one reason why we only have four stocks (out of over 1,600) that have moat ratings of "none" and below-average risk.

You might think of the relationship between the width and depth of a company's economic moat like this:

Wide Moat, High Returns on Capital
The sweet spot--companies with sustainable and high returns on capital. These are likely to be the market's best companies, and they are suitable to be core holdings in your portfolio.

Wide Moat, Lower Returns on Capital
Your second-best option--firms that are likely to maintain their competitive positions for a long time, but which are not earning enormous returns on their capital base. They're likely to be more-mature, steady Eddie companies.

No Moat, High Returns on Capital
Companies that can be quite profitable but whose fortunes can turn on a dime. Think of young technology companies, hot retailers, or popular restaurant chains. They are worth buying with the right margin of safety, but keep them on a short leash.

No Moat, Low Returns on Capital
The dregs of the market--capital-intensive firms that struggle to earn occasional excess returns in competitive industries. Most chemical companies, airlines, and auto-parts suppliers would land here.

Two-Dimensional Moats
Since we think the sustainability of a firm's competitive advantage is more important in the long run than how much money it can make it the short run, that's the basis of our economic moat ratings. However, don't ignore the depth of a company's moat, since there's just as big a difference between Adobe and Pitney Bowes as there is between Aeropostale (none/deep) and an auto-parts company.